Pay Down Variable HELOC or Fixed Mortgage?

Whenever I have a money question, I go to Cash Commons. There, users ask and answer all sorts of questions in a very helpful way. When I received this question, it seemed like a matter of opinion, so I wanted to get a few views on what the best idea way, and more importantly, why.

Matt asks:

I have both a mortgage on our house, and a home equity line of credit. The mortgage rate is fixed (4.4.%) for 15 years. The home equity is variable, right now, it is only 2.24%. I am trying to accelerate payments beyond the minimum to get out of debt more quickly.

When the home equity rate is higher than the mortgage rate, it is a no-brainer – pay the minimum on the mortgage and throw any extra money into the home equity loan.

However, when the home equity loan is lower, like now, it is a little more tricky. It may seem obvious to pay the minimum on the home equity and pay off more of the higher interest mortgage. That would be the clear choice, if I could count on not needing to tap the home equity line down the road. But, what if I anticipate some large expenses down the road, for which I would need to borrow?

If my home equity is close to the ceiling, then I won’t be able to borrow against it when I need it. No matter how much I’ve paid off my mortgage, I can’t get more from that source if I need it. So, what’s the best strategy in this situation? (And, you can ignore the issue that as the home equity gets closer to the ceiling, that hurts my credit rating a little. For the current purposes, I don’t anticipate taking out any other loans, and I pay my credit cards off each month.)

After posting this question over at Cash Commons, I got some interesting opinions.

After breaking down the situation, Mighty Bargain Hunter was a proponent of building up cash reserves, then paying down the Home Equity Line of Credit (HELOC), then the mortgage. He argues that cash in the bank buys time, even if it costs a little in the short run and that the rate on the HELOC will eventually increase to a rate higher than the mortgage, making it worth it. I agree that the cost of building up cash is low (Matt would lose less than 1/2 a percent in interest if he chooses a savings account instead of the HELOC).

Dr. Dean agrees and says that rates will rise this year so the HELOC should be the biggest concern, and the more that is paid in the short-term, the less left over there will be when the rates increase considerably. Again, a good point, and he notes that what the market will do in 2010 is his main reason for his thinking. Plus, if rates continue to stay low, he can always try to refinance to keep his mortgage rate low for far into the future.

My take is a little big different. It’s extremely hard to know what will happen in the next year in terms of the market. At some point, interest rates will rise, and when they do, some think they will rise to a high rate in a short period of time. Whether this happens in the next year, nobody knows for sure.

The uncertainty of the situation is what makes this question difficult. Right now, Matt can make larger payments on the mortgage and effectively “earn” 4.4% on his investment. Alternatively, he can pay down the HELOC, “earn” 2.4% in the short-term, and when the interest rates rise, “earn” more. But when will the interest rates rise to 6 or 7%?

Since it’s impossible to know, I am a proponent of taking the guaranteed return after building up some cash reserves. That way, Matt can pay off a chunk of the HELOC when the interest rates rise while only “losing” 2.4% (4.4% on the mortgage – 2.% that he can earn with a savings account such as SmartyPig), and then earn that 4.4% by paying off the mortgage. In this scenario, he doesn’t take too much risk, spreads out his “investments” slightly, and knows what kind of return he is getting.

When the interest rates on the HELOC begin to rise, it may be time to switch to making payments there because once the markets improve (whenever that may be), they may rise quickly and it will make sense to pay that down as quickly as possible. But until then, my vote is to pay the mortgage and earn a guaranteed return on your investment rather than trying to time the market to come out slightly ahead.

When do you think interest rates will rise? Do you have other advice for Matt or a different reason than the ones outlined above? Let me know in the comments!

Pay Down Variable HELOC or Fixed Mortgage?

Sweating the Big Stuff

10 thoughts on “Pay Down Variable HELOC or Fixed Mortgage?

  1. Hi Daniel,

    You need to take tax into account too, from my reading of the situation.

    Paying off the mortgage is worth more than 4.4% because the ‘saving’ being made isn’t taxed (though it might be slightly different with you guys in the US, since you get tax relief on mortgages I think?)

    In contrast, his 2.2% savings will presumably be taxed?

    I agree you don’t want to have no cash though – some liquidity is important, even if as I read this the mortgage payments can effectively be taken back out if a need for cash arises.

    1. @Monevator,

      Paying off the mortgage is worth LESS – you receive tax benefits on the mortgage interest. That’s an imprtant point, the 4.4% interest rate on the mortgage is probably slightly lower. Still, the question is still a little difficult – variable or fixed?

      1. @Daniel, Wow, you guys need to get rid of mortgage tax relief. We ditched it in the early 1990s. It’s unfair to penalize renters just for making a different consumption choice. My view anyway. Anyway, as you say you must take tax into account with these ‘foregone savings’ type equations (and tax will offer differ from person to person).

        1. @Monevator, Gosh, apologies I’ve just re-read the post (I skimmed it due to talking about HELOC and other US terms I don’t really use) and assumed it was a pay off the 4.4% or save at 2.2% type question.

          Re-reading and making assumptions about tax, I think he should pay off the higher rate loan first. My final answer! ;)

  2. I’m not a financial wiz, but because his HELOC is at such a low interest rate, I think it would better for him to pay it down. That way it will be less debt hanging over his head. He also mentions that the HELOC is at a variable rate, meaning it might increase later in the year. Since his 4.4% mortgage is fixed for 15 years, he has time to pay more towards it down the road.

  3. I’m in the exact boat with my 2nd mortgage. I’m hoarding cash to build a full emergency fund on 4 months expenses then I’ll attack my fixed rate first. If interest rates get crazy then I’ll go after the variable portion. I think they key I would get across is to not even be contemplating the idea of using that home equity account as your buffer. Get it done close it and move on.

    1. @Paul @ FiscalGeek, Awesome, I like your plan, it’s fantastic to hear from someone who is having the same experience. Thanks!

  4. First, HELOC is the same as a mortgage in terms of tax credit. Both are deductible. So, the actual interest rate on the home mortgage is about 3-3.2% depending on tax bracket, and the HELOC now is about 1.6-1.7%. I don’t understand the recommendation to put money in savings at 2% – remember, you do pay taxes on the interest earned, so the next is about 1.4-1.5%. Why not just pay off the higher 4.4% rate as quickly as possible, and then just switch and pay off the HELOC at whatever point in the next couple of years that it shoots above 4.4%


  5. Definitely pay off the higher interest rate first. I think the variable HELOC loan will be sub 3.5% for a long time. Rates aren’t going much higher.

    I have a similar structure where I’ve arbitraged $100K of a HELOC at 3% to pay down my primary loan principal by $100K.

    Rates are so freaking low right now, it’s awesome!

  6. I think there’s one more complicating factor. Let’s assume, as Steve said, he puts more into the 4.4% mortgage payments, and leaves the HELOC pretty high. That’s fine as long as the HELOC rates are lower. But, when HELOC gets higher, he won’t have the ability to cut his mortgage payments! The bank requires the minimum mortgage payment, even if you’ve cut the principal. So, at some point he may still have to make the minimum mortgage, but now have to also pay off as much of the higher HELOC as possible. If you have enough income to cover, great. But, if not, in long run you’ve dug yourself a deeper hole.


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